Buoyant Economies

The guided exchange rate system 

The Guided Exchange Rate System (GERS) is an exchange rate system designed to exist in the context of variable market determined exchange rate system.  It facilitates the management of monetary flows to ensure balance of payments stability and provides for the central bank to influence the exchange rate to ensure international competitiveness and maintain economic growth. 

The GERS manages the growth of bank credit with an approach based upon the fractional reserves banking system linked to a reserve fund.  It requires commercial banks to hold a “Reserves and Settlement” account with the central bank.  Inter-bank settlements must be made through these accounts.

Commercial banks would be able to increase their lending by, say, ten dollars (or units of local currency) for every one dollar increase in their Reserves and Settlements account.  The central bank would be free to vary that rate. 

Commercial banks would be able to increase their balance in their Reserves and Settlements account by selling foreign exchange to the central bank.  Commercial banks would not be able to increase the balance of their Reserves and Settlement account by selling any government or private securities to the central bank.

The central bank could offer to buy and sell foreign exchange at the rate of, say, 2 dollars to the equivalent of a special drawing right (SDR) and credit their Reserves and Settlement account.  That exchange rate would be the central bank’s guiding exchange rate. 

The central banks of most countries are likely to set their guiding exchange rates in terms of a basket of currencies.  Although the central bank would be free to vary the guiding exchange rates at any time, it would be unlikely to do so on a regular basis.  The guiding exchange rate would be an instrument of monetary policy and the central bank would be unlikely to vary it unless it had reason to change it. I would expect that a central bank would choose to vary the guiding exchange rate in much the same way as they vary interest rates: at irregular intervals and in small increments.  Even so, it is likely that the exchange rate for specific currencies would vary according to movements in those exchange rates relative to the basket of currencies used to define the guiding rate. 

The central bank’s offer to exchange foreign currency at a specified rate means that there would be little exchange rate risk for commercial banks to hold foreign exchange.  If commercial banks were allowed to hold foreign exchange, it may reduce the need for them to trade foreign currency with the central bank.  To this end, it would be advisable to allow commercial banks to hold a some foreign exchange.  It may contribute to exchange rate stability, allowing commercial banks to trade foreign currency with other traders in the foreign exchange market.

The central bank’s holdings of foreign reserves should be greater always than the sum of the Reserves and Settlements accounts and currency in circulation.   

The central bank would not be guaranteeing the value of the local currency. It would only guarantee to pay the guiding exchange rate on the funds held in the commercial banks’ Reserves and Settlements accounts.  Therefore, it dos no hold any significant exchange rate risk.  If it chooses to devalue, the value of its foreign exchange holdings would increase while its liabilities to the commercial banks would not.  It would only be if the central bank chose to revalue the currency that it would experience any loss on foreign exchange.  In that case, it would be choosing to make that exchange rate loss.

The central bank would not be setting the exchange rate of the local currency.  The market would be free to trade above or below the central bank’s guiding exchange rates.  Of course, if a bank with foreign currency were offered less local currency on the market than it could recover under the central bank’s guiding rate, the commercial bank would be likely to sell those funds to the central bank and credit its Reserves and Settlement account.

The central bank should pay interest on the balances of the Reserves and Settlement accounts. It would be free to vary that rate and would, thereby, influence market interest rates.

If a commercial bank with surplus funds in its Reserves and Settlement account were seeking to buy foreign currency and the market price were higher than central bank’s guiding exchange rate, the commercial bank may choose to buy the foreign currency from the central bank at the guiding rate.  The central bank would not sell foreign exchange to a commercial bank if by doing so it would reduce the commercial bank’s reserves below the minimum amount necessary for the bank’s level of outstanding loans.

The central bank would not be participating in all international exchange transactions.  The foreign exchange market would continue to persist for usual day to day international transactions. The central bank’s guiding rate would only influence the value of the Peso on the foreign exchange market. 

The central bank would be free to enter the foreign exchange market at any time and buy and sell currency on its own account.  If the central bank were to issue loans or buy securities, it too should have a Reserves and Settlement account and its lending, including lending to government in any form, should be governed by the same rules as apply to commercial banks.       

 Commercial banks wishing to buy local currency (notes and coins) from the central bank would pay for that currency with funds from their Reserves and Settlement account.  The central bank would credit commercial banks’ Reserves and Settlements accounts for any currency returned.

To explain the process in more detail, let us assume that the following account is the consolidated balance sheets the commercial banks: 

 Let us assume that the following is the balance sheets of the central bank. 

Let us assume that under the GERS, the fractional reserves ratio is ten dollars of lending for every one dollar in the Reserves and Settlement account.

Now let us assume that the central bank buys $10 billion of foreign currency from the commercial banks.  In effect, the commercial banks would make the following entries in their consolidated accounts. 

As a result of this transaction, the consolidated balance sheet of the commercial banks would be: 

For the same transaction, the central bank would make the following entries in its accounts. 

As a result, the central bank’s balance sheet would be: 

The effect of these transactions has been displayed graphically in Figure 1.  Let us assume that there is initially no growth in bank credit and there are no net international capital flows.  Exports, which could include remittances, are shown as the X-X line.  Imports are given by the M-M line.  The equilibrium exchange rate is at e_1.  Exports are equal to imports which are equal to 0-A₁.  Expenditure on and income from domestic production is equal to A₁-Z₁.  National income is given by the Y1-Y1 line and is equal to the interval 0-Z₁.   

Figure 1. GERS with increased foreign reserves and increased income

Now we introduce the GERS and the commercial banks take advantage of the central bank’s guiding exchange rate at e₂ to buy $10 billion.  The additional supply of domestic currency (or demand for foreign currency) is shown as the M+Fr line.  Even if there were no increase in the physical amount of exports, given the greater number of dollars paid for foreign currency with the lower exchange rate of e₂, the value of exports to 0-A₂.  The lower exchange rate has made imports relatively more expensive, so imports fall to 0-A₃.  The increase of $10 billion in foreign reserves sold to the central bank is represented by the interval A₃-A₂.

Expenditure on domestic production rises for A₁-Z₁ to A₃-Z₁.  National income is made up of foreign income and domestic income, comprising exports of 0-A₂ and income from domestic production A₃-Z₁.  This means that national income has risen by the equivalent of the growth in foreign reserves, taking the new level of income to Y₂-Y₂ at Z₂.

Theoretically, these additional reserves would enable the banks to lend an additional $100 billion.  But as the banks start lending, they increase the demand for imports, shifting the imports schedule to the right.  Also, at the higher level of income, demand for imports has increased. These transactions are likely to reduce foreign reserves and so check the growth of bank credit. 

To consider this outcome, let us assume that the commercial banks increase lending by $15 billion and it is all spent on imports.  Also, the increase in income raises expenditure on imports by $3 billion. The net effect is that the demand for imports has increased by $18 billion. 

This outcome is presented in Figure 2.  Demand for imports has now shifted in shifted to the right by $18 billion to M₂-M_2.   This raises total expenditure to the E – E line which is equal to income represented by the Y₂-Y₂ line plus the growth in bank credit.

If the foreign exchange market were to fully determine the exchange rate, the exchange rate would fall to e₃.  At that point, exports and imports would rise to A₄.

We will assume that the commercial banks decide to buy $8 billion of foreign exchange from the central bank.  In that case, the exchange rate stays at e₂ with exports still at A₂ while imports are at A₅.               

Figure 2: GER with reduction in foreign reserves and increased income

National income is made up of income from exports (0-A₂), plus income from the sale of domestic products (A₅-Z₃).  Although imports were greater than exports, national income rises from 0-Z₂ to 0-Z₃, equivalent to an additional increase of $7 billion.  This increase in income is derived from the increase of $15 billion in national expenditure less the income lost because imports exceeded exports by $8 billion. 

In the initial stage, presented in Figure 1, there was a current account surplus and growth in foreign reserves of $10 billion.  In the second stage, presented in Figure 2, there was a current account deficit of $8 billion.  The net effect over the two stages is a rise in foreign reserves of $2 billion.  This net growth in foreign reserves is sufficient relative to the current level of new loans.  However, it is sufficient for only a small increase in bank credit.    

National income has increased $10 billion in the first stage and by an additional $7 billion in the second stage to grow an additional $17 billion relative to national income at the start.

The transactions that affected the balance sheet of the commercial banks were the loans issued and the purchase of foreign exchange. These can be journalised as:    

When these are presented in the consolidated balance sheet for the commercial banks, the outcome is as follows: 

The net effect of these transactions is that, under the GERS, deposits have increased $17 billion, loans have increased $15 billion and reserves have increased $2 billion. 

For the central bank, the only relevant transaction affecting the balance sheet was the sale of $8 billion in foreign reserves, shown below: 

When this is included, the central bank’s balance sheet becomes: 

In this series of transactions using the GERS, there has been a net increase in commercial bank lending of $15 billion.  Foreign reserves have increased $2 billion and the net current account surplus was $2 billion.  Using the GERS, it is possible to achieve small current account surpluses or a balanced current account.     

The GERS offers the central banks a number of levers for guiding the economy.  Central banks can influence the exchange rate by determining the guiding exchange rate.  Devaluing the guiding exchange rate would stimulate employment and economic growth.  Devaluation may have a small inflationary effect as the price of imports would rise. 

It should be noted that the exchange rate affects not only relative prices, it also drives the growth of foreign reserves, the growth of bank credit and monetary growth, generally. 

Central banks would use the interest rates it pays on deposits in the Reserve and Settlement account to influence the interest rate commercial banks charge on loans and pay on deposits.  

Note that because interbank settlements are made using the Reserves and Settlement account, any bank that loses deposits to other banks would suffer falling reserves.  Lower reserves would preclude the bank from increasing lending. Therefore, commercial banks must pay competitive interest rates to attract deposits 

By influencing interest rates, the central banks also regulate the rate of foreign capital inflow.  If rate of growth of foreign reserves was not sufficient to allow commercial banks to increase their lending, the central bank could raise interest rates.  That would attract foreign capital and raise the foreign reserves of the banking system, allowing the commercial banks to increase lending.  

The central bank manages the fractional reserve ratio, also.  If the central bank sought to increase lending without attracting foreign capital, it could raise the fractional reserve ratio.  Alternatively, if there were excessive inflation and the central bank sought to slow monetary growth without attracting foreign capital, it could lower the ratio, increasing the cost of lending for commercial banks.   

Inflation would tend to be lower under the GERS than under pure floating exchange rate system because the GERS results in higher rates of economic growth relative to the level of monetary growth. 

Prices tend to increase by the square root of the rate of monetary growth over the rate of economic growth.  If the rate of monetary growth were equal to the rate of economic growth, there would be no inflation.  If the central bank sought to achieve economic growth at rate a rate of, say, 10 per cent and inflation of, say, 3 per cent, it would need monetary growth of about 16.7 per cent.  Such rules of thumb gained with experience would enable the central bank to monitor and guide the monetary system to achieve the economic objectives for which it was established.

For example, achieve monetary growth of 16.7 per cent per annum, the central bank could regulate bank lending so as to allow monetary growth of 1.3 per cent per month.  If monetary growth were excessive, it could raise the guiding exchange rate to slow the rate of economic growth and the growth of the money supply and reserves.  If monetary growth were inadequate, the central bank could lower the guided exchange rate to stimulate export growth and reduce imports, thereby stimulating the domestic economy, raising the rate of growth of the money supply and of foreign reserves.

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Last update: 6 March 2010